Weekly Thoughts: The Data Advantage

The Data Advantage

How is big data relevant to the world of small business?

As our readers know, we are entrenched in the world of small business. Despite our widespread affection for small, local businesses, the reality is that this segment of our economy is shrinking. A New York Times Op-Ed shares some anecdotal observations about this shift:

“[M]any small businesses have struggled to keep up with the new corporate giants and with foreign competition. You can probably see a version of the story in your community. The hardware store has given way to The Home Depot. The local hospital and bank are owned by a chain. The supermarket is Whole Foods, which is now owned by Amazon. The family-owned manufacturer may simply be out of business.”

Back in the 1980’s, small companies, in aggregate, accounted for more employment than their larger counterparts. Since then, larger firms have gained share in the workforce at the expense of smaller firms, which means that today, people are more likely to work for a company with more than 10,000 employees than a company with less than 50. The New York Times illustrates the magnitude of this change:

So what’s going on here? First, from an investment theory standpoint, it’s important to note that larger firms tend to have “more stable revenue streams, and more collateralizable equipment, are less risky creditors and thus pay lower risk premia,” which basically means big companies are more financially predictable and therefore have better access to funding. In contrast, small companies, which can have volatile financial performance, are often shut out of capital markets, which inhibits growth. This volatility gap has been consistent for decades however, and does not explain why the growth gap began to widen sharply in the 1980’s.

On that point, a recent Journal of Monetary Economics article titled Big Data in Finance and the Growth of Large Firms co-authored by professors at Stanford, MIT Sloan, and Columbia, provided some insights. In the article, the authors argue that rapid advances since the 1980’s in data and computing power – i.e., “big data” – has provided large companies with ever cheaper access to capital relative to their smaller counterparts. Their research explains further:

“Large firms are more valuable targets for data analysis because more economic activity and a longer firm history generates more data to process. All the computing power in the world cannot inform an investor about a small firm that has a short history with few disclosures. As big data technology improves, large firms attract a more than proportional share of the data processing. Because data resolves risk, the gap in the risk premia between large and small firms widens. Such an asset pricing pattern enables large firms to invest cheaply and grow larger.”

Basically, more data equals less uncertainty, which in turn, lowers the cost of capital. Furthermore, the authors point out that the data doesn’t even need to be positive, it just needs to exist. From the research:

“An investor who has a more accurate estimate is less uncertain and bears less risk from holding the asset. The representative investor is willing to pay more, on average, for a firm that they have good data on. Of course, the data might reveal problems at the firm that lower the investor’s valuation of it. But on average, more data is neither to reveal positive nor negative news. What data does on average improve is the precision and resolution of risk. Resolving the investors’ risk reduces the compensation the firm needs to pay the investor for bearing that risk, which reduces the firm’s cost of capital.”

From our standpoint, a significant underlying factor contributing to the increasing disparity between data availability in small companies relative to their larger brethren is the lack of internal resources available for—or allocated to—implementing the systems that actually create good data. More bluntly put, most small businesses simply don’t have the systems to generate operational business intelligence or solid financial reporting packages. The value of this kind of cohesive and comprehensive data is a compounding phenomenon (good data leads to better insights which begets even better data and so on), so as a result, smaller companies suffer from an expanding deficiency of the benefits data can provide.

When we acquire a business, it enters what has been colloquially dubbed the “Chenmark Car Wash” which is basically a systematic review and installation of systems to support the generation of data for the purposes of enhanced business intelligence. This endeavor requires a huge financial and time commitment and is often a slow and arduous process. Over time however, the integrity and timeliness of the data improves greatly, which in turn provides our family of companies with access to the data advantages enjoyed by larger entities. So, while we might not be able to stem the tide of resources flowing towards larger entities, our hope is that in some way, our efforts in this area can allow the small business ethos to remain alive and well within the Chenmark family.